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Shadow inventory improves but still threatens housing recovery

By Les ChristieAugust 22, 2011: 6:58 AM ET

NEW YORK (CNNMoney) -- An ominous cloud is hanging over the housing market: Millions of distressed properties could be put up for sale at any moment, potentially adding to the glut of unsold homes that are already on the market and depressing home prices even further.

But there is one glimmer of hope in this otherwise ominous scenario. A recent report from Standard & Poor's found that the time it would take for banks to purge all of this so-called "shadow inventory" from the market (through foreclosure sales, mortgage modifications and other measures) shrunk to 47 months during the second quarter, a significant drop from the 52 months it estimated for the first quarter of this year.

The report also found that the total dollar value of the loans on these properties -- known as non-agency loans because they are not backed by Fannie Mae, Freddie Mac or the Federal Housing Administration -- also fell to $405 billion at the end of June from $433 billion three months earlier.

"It's good news that things are starting to slow down and we're getting closer to the end of the problem," said Diane Westerback, Managing Director of Global Surveillance Analytics for S&P. "It could mean a gradual recovery for the market."

S&P said the decline was helped by stabilizing liquidation rates and by fewer borrowers falling behind on their mortgage payments as the economy slowly recovered during the quarter. The firm also said tightened lending standards over the past several years has helped reduce the likeliehood of defaults among recent homebuyers.

Yet, the housing market still has a long way to go. S&Pestimates that there are still a total of between 4 million and 5 million homes, including those with agency-backed loans, in shadow inventory, an amount that continues to jeopardize the housing market's recovery, according to Westerback.

When all of the shadow inventory finally makes it to market, it will likely do so at a deep discount, weighing on overall home prices and depressing values further, said Westerback.

As many recent foreclosure reports have warned, many homes that should currently be going through foreclosure aren't doing so because banks have been slow to process the paperwork or initiate the proceedings following the robo-signing scandal. As a result, many homeowners who are delinquent on their mortgage payments have been able to stay in their homes.

"There's a big asterisk on shadow inventory numbers," said Anthony Sanders, director of real estate entrepreneurship at George Mason University. "In many states, the banks have slowed foreclosure filings to a crawl."

The first filings issued to delinquent borrowers may come many months after they stop making their regular mortgage payments. RealtyTrac, a marketer of foreclosed homes, analyzed all the initial notices of default filed in California this year and compared them with filings from 2007.

The total of missed payments for the recent filings came to an average of $78,000 per borrower, up from $17,000 four years earlier. To RealtyTrac spokesman, Rick Sharga, that indicated that banks were postponing the notices for many more months than they used to.

Out of the shadows

Homes fall out of shadow inventory when banks repossess and resell the homes, when their owners sell them, or when they're cured, that is, when borrowers catch up on their mortgage payments and remain up-to-date.

Since borrowers with cured loans often redefault, S&P counts 70% of all cured loans as part of the shadow inventory.

Although the S&P data only covers non-agency loans, the authors said similar dynamics apply to loans held by the government-sponsored mortgage giants, Fannie Mae and Freddie Mac.

The difference is that, since Fannie and Freddie absolutely dominate the mortgage lending market today, and have done so since the bust, much of their portfolios are in recently-issued loans, which were very strictly underwritten. As to be expected when the banks are being far more careful in who they lend to, the default rates for recent loans is much lower and so the government agencies have a lower percentage of their loans in shadow inventory than do the banks.

Nevertheless, Fannie and Freddie are looking to rid themselves of a large percentage the shadow inventory they do have -- and quickly. Earlier this month, the Federal Housing Finance Agency (FHFA), the Treasury Department and the U.S. Department of Housing and Urban Development were seeking suggestions on how to dispose of the 92,000 repossessed homes now owned by Fannie Mae, Freddie Mac and the Federal Housing Administration in a way that would benefit local communities.

Getting rid of the government's shadow inventory in a way that won't further depress home prices will be tricky, however. And the government's homes are only a fraction of the shadow inventory out there.

As long as homes remain in the shadows, the housing market will have a hard time recovering.

"The big issue is that homebuyers understand that there's a backlog of houses that could flood the market at any time," he said. "I could buy a home in Las Vegas and the banks could release a lot of repossessed homes back on the market and drive down prices 10%."

That lowers confidence for many potential homebuyers to the point where they are hesitant to pull the trigger on home purchases.

"Homebuying is scary enough already these days," said Sanders. "Throw in the shadow inventory and it's pretty darn grim."